Hoaxwagen

How the massive diesel fraud incinerated VW’s reputation—and will hobble the company for years.

How the massive diesel fraud incinerated VW’s reputation—and will hobble the company for years to come.

In late 2008 a publication called Green Car Journal compared the five finalists of its annual Green Car of the Year award. “Fulfilling this growing desire for vehicles with better fuel economy and overall environmental performance is no easy thing,” it noted. “Rising to the top is the 2009 Volkswagen Jetta TDI.” The car was the winner because its “groundbreaking clean diesel” engine managed to meet America’s “stringent tailpipe emissions standards” while also delivering “admirable fuel efficiency,” “satisfying performance,” and “a very reasonable” price.

That award was recently rescinded. The Jetta—like at least 14 other so-called Clean Diesel models sold by Volkswagen Group under its VW, Audi, and Porsche marques from 2008 to 2015—was actually the automotive equivalent of Piltdown Man. It was a hoax.

About 580,000 VWs in the U.S.—and almost 10.5 million more worldwide—weren’t really “green” at all. As the world began to learn in September, when the U.S. Environmental Protection Agency issued a shocking “notice of violation,” the vehicles met emissions standards for dangerous oxides of nitrogen, known collectively as NOx, only when running their paces in an artificial, indoor lab setting. Volkswagen has admitted this. Software in the engine recognized the telltale signs of the testing regimen and turned up the emissions-reduction equipment when its exhaust was under scrutiny. But once the car was driven onto actual roads, the equipment adjusted and the vehicle disgorged up to 40 times the permissible levels of NOx.

For seven years Volkswagen’s advertising campaigns flogged these vehicles’ bogus eco-friendly credentials in print, media, and even Super Bowl commercials. In one memorable example, the “green police” stop a long line of smog-belching cars but wave a lone, righteous diesel from VW’s Audi division through with a cheery, “You’re good to go, sir.”

“Hoax,” of course, is a layman’s word. But plenty of legal terms also arguably apply, including “consumer fraud” and “false advertising.” They are fueling an explosion of litigation. That and the horrific reputational damage are subjecting Volkswagen to one of the severest challenges in its nearly 80-year history.

The U.S. Department of Justice and the EPA have filed a civil suit that could theoretically subject VW to up to $45 billion in fines (though, in fairness, no one expects penalties quite that draconian). The DOJ and the EPA are also pursuing a criminal inquiry, as are prosecutors in Germany, France, Italy, Sweden, and South Korea. All 50 state attorneys general in the U.S. are also on the warpath, armed with state laws that, nominally at least, are every bit as crushing as the federal law.

All of that comes on top of more than 500 class actions filed on behalf of owners and lessors of Volkswagen diesel cars—an unprecedented number, according to Elizabeth Cabraser, a leading mass-disaster plaintiffs attorney who is heading a 22-lawyer steering committee trying to bring order to the sprawling mess. There are also class actions by used car dealers, dealers for competing models (such as Chevy diesels and Toyota hybrids) who claim unfair competition, and shareholder suits.

In part, the huge number of suits reflects the fact that plaintiffs lawyers smell blood. Volkswagen has already made public admissions that come close to conceding legal liability. “This is not a whodunit type of case,” said federal judge Charles Breyer, who is overseeing the litigation, at a hearing in January.

The numbers also reflect genuine rage at VW. An extraordinary number of educated middle-class or affluent plaintiffs feel deliberately snookered on a subject they are passionate about. Unlike in Europe, where more than half the cars are diesels, they are rarities in the U.S.—about 0.5%—and they cost more than gasoline-powered models. Accordingly, Americans chose them specifically for a trait that turned out to be a lie. Says Cabraser: Diesel buyers are “looking for the sweet spot between high mileage, performance, and environmental responsibility. They read Consumer Reports, do comparison shopping, do the math. They were highly invested in these vehicles … They were attempting to protect and preserve the environment.”

Volkswagen has set aside 6.7 billion euros ($7.3 billion) to make its cars comply with emissions rules—but the sum doesn’t begin to take into account the fines, compensation, restitution, and attorneys’ fees the company will eventually have to fork over. U.S. regulators rejected VW’s first recall proposals in December, and at press time it was still not at all clear whether they’ll ever approve “fixes” for many U.S. cars, or whether they will demand VW buy them back instead. In late February an angry Judge Breyer twisted the vise even tighter, ordering the company to determine, by March 24, whether it can fix the cars.

VW has skidded into the guardrails at every turn since the scandal emerged. Even its attempts to project contrition so far have been ham-fisted, halfhearted, and fumbled. CEO Martin Winterkorn quickly resigned, top executives apologized, a number of engineers were suspended, and the company appointed an American law firm, Jones Day, to perform an internal investigation.

But the company’s new worldwide CEO, Matthias Müller, infuriated regulators with legalistic hedging and excuses in an interview with National Public Radio in January. “It was a technical problem,” he told NPR. “We had not the right interpretation of the American law … We didn’t lie. We didn’t understand the question first.” (Volkswagen declined to make Müller or other executives available for interviews. The company answered a handful of questions in writing but declined to comment on the vast majority, stating, “These topics are subject to ongoing investigation or to privacy protection.”)

VW’s misbehavior did not come out of nowhere. The company has a history of scandals and episodes in which it skirted the law. Each time—till now—it has escaped without dire consequences.

The company’s immense power, it seems, meant never having to say it was sorry, at least not in Europe. VW has a legacy as a quasi-state entity that has long steamrolled regulators there. The company and the auto industry are so crucial to Germany that Chancellor Angela Merkel has repeatedly intervened to stave off or weaken emission regulations.

VW is driven by a ruthless, overweening culture. Under Ferdinand Piëch and his successors, the company was run like an empire, with overwhelming control vested in a few hands, marked by a high-octane mix of ambition and arrogance—and micromanagement—all set against a volatile backdrop of epic family power plays, liaisons, and blood feuds. It’s a culture that mandated success at all costs.

Volkswagen’s goals were audacious: It aspired to be the biggest seller of cars in the world under Piëch protégé Martin Winterkorn. Sales of U.S. diesels were crucial to the mission. The company has continually protested that top executives—otherwise noted for their punctilious attention to detail—were ignorant of misbehavior. But the evidence suggests, at minimum, that some were alerted to possible cheating well before it became public. Even before that point, one has to wonder how the brass could have been blind to conduct that was so central to achieving the company’s goals.

The company has acknowledged and even apologized for the fact that its diesels used dual-strategy software worldwide. (It has largely blamed a handful of rogue engineers.) Yet VW has steadfastly denied that its software constituted an illegal “defeat device” as the term is defined under European law. It has refused to offer its millions of European customers any compensation.

In Europe, some think the American reaction to the scandal is overwrought, driven by contingency-fee lawyers and politicians eager to help domestic automakers gain ground against a European rival. After all, General Motors paid a comparatively modest $900 million to settle a federal criminal inquiry relating to faulty ignition switches that led to the deaths of 124 people. Even the EPA has acknowledged that all diesel cars together account for only about 0.1% of NOx in America’s air supply.

But emissions aren’t a mere abstraction—NOx kills. Consider the impact of diesel engines in Europe, where three-quarters of the world’s diesels are sold. According to the European Environment Agency, 500,000 people there died prematurely in 2012 as a result of poor air quality. The biggest contributors were cancer-causing particulate matter and nitrogen oxides. Diesel engines are the biggest source of NOx and a significant emitter of particulate matter. (VW flatly denies, in its written statement to Fortune, that NOx represents any proven health threat. “The scientific data currently known to us does not give a clear picture of the effect of nitrogen oxide in environmental concentrations on people and no completely validated statements can be made about the actual risk potential.”)

But if the environmental agency’s science is correct, then those disturbing numbers point to a broader problem: Europe has favored diesels and looked the other way when automakers—including but hardly limited to VW—game the system. Emissions Analytics, a U.K.-based consulting company, says it has tested the real-world emissions of more than 400 diesel cars. Only five (including one Volkswagen) actually met the standard they were licensed to, according to CEO Nick Molden. “On average, diesels were emitting four times the regulated maximum,” he says. “Volkswagen was in the middle of the pack.”

Who Governs Whom?

It’s difficult to exaggerate how intertwined Volkswagen is with German institutions—from its government, politicians, and regulators to its unions. It was conceived, of course, by Adolf Hitler, who wanted it to spread mobility to the masses the way that Henry Ford had done. VW was nationalized after World War II and returned only fitfully to private ownership.

All these decades later, VW remains formally connected to the government. Lower Saxony, the state where the company is based, owns 20% of its voting rights, but the state’s power is even greater than that. By law, Lower Saxony has been granted veto power over VW’s strategic decisions.

Then there are the informal connections: Gerhard Schröder, who was Chancellor before Merkel, and Sigmar Gabriel, who is currently her vice chancellor, have both served as VW directors in their function as governors of Lower Saxony.

The nexus between the company and the government that is supposed to regulate it could hardly be tighter. Traditionally Lower Saxony has used its powers to encourage creating and maintaining jobs within the state. More than 110,000 of VW’s worldwide labor force of 589,000 work at its immense headquarters in Wolfsburg and four other plants in Lower Saxony.

That employee base has helped give VW massive clout. Time and again the German auto-industry—the largest in the country—has been able to brandish the threat of job losses if legislation contrary to its interests is passed. The result: a patchwork of regulation watered down to the point of meaninglessness. In 2009, for example, the German government amended its rules so that inspections of emissions performance would be based solely on readings from a car’s own “onboard diagnostic” system, effectively ceding total control to the automakers.

At VW, at least, regulators wield less power than unions. By law, labor receives board representation at all but the smallest German companies. Time and again the Works Council, or Betriebsrat, which holds eight of VW’s 20 board seats, has played a decisive role, mobilizing the support of the state government to get its way over the interests of private shareholders.

German Chancellor Merkel with Mattias Müller, who has since become VW CEO, and Martin Winterkorn.Odd Andersen—AFP/Getty Images

“Victory Is Fun … but I Can’t Celebrate”

One man, at least, was able to impose himself on this formidable and politicized structure: Ferdinand Piëch, a brilliant engineer and a ruthless, terrifying manager who dominated VW for more than two decades. Chief executive from 1993 to 2002, and chairman from 2002 till early last year, Piëch, now 78, infused VW with an ambition and drive that made the most of its political heft, presiding over a culture that was, if not above the law, then not above stretching it, by many accounts.

In large measure VW owes its scale and its culture to Piëch—who was more or less born into Volkswagen. He is the grandson of Ferdinand Porsche, who built cars for the Austro-Hungarian imperial family before World War I, long before Hitler tapped him to build the People’s Car. After World War II, Piëch’s uncle Ferry Porsche led a de facto research and development center for VW, an arrangement that provided income to build the sports cars for which Porsche is now famous. Meanwhile Piëch’s formidable mother, Louise, created an import, sales, and servicing network that became Europe’s largest car distributor.

The quest for colossal achievement and a contempt for anything that gets in the way or falls short run like parallel threads through Piëch’s life. In his own account, Auto. Biographie, he comes across like the demonic oil prospector Daniel Plainview in There Will Be Blood when he writes, “The struggle for victory is fun, but I can’t celebrate something once it’s been won.”

Overcoming dyslexia, Piëch became an engineer and joined Porsche in 1963. He squabbled constantly with his cousins, not least when he risked the company’s future by overspending to complete the 917 (which became Porsche’s most successful race car). Years of infighting drove the family to remove its members from company management. Piëch didn’t improve relations with the Porsches when he later had two children with the wife of his cousin Gerhard, adding to the five he had had by his own first wife; five more with two other women followed. The family hostilities would reach an apex decades later, when Porsche tried to acquire VW, and Piëch outmaneuvered his cousins and ended up swallowing Porsche instead.

When Piëch resurfaced in 1972 at Audi, by then owned by VW, he dragged it upmarket almost single-handedly with a series of engineering innovations, such as the four-wheel drive system for the Quattro. Under Piëch, Audi was also the first to enjoy commercial success with a technology called “direct injection” in diesel cars. Later generations of the technology would become an industry standard, including for VW’s Clean Diesels.

Ferdinand Piëch, the man most responsible for the modern Volkswagen.Nigel Treblin—AFP/Getty Images

“I Will Replace All of You”

It was at Audi that Piëch developed his reputation for utter ruthlessness with subordinates. “I consciously allow those in whom I’ve lost trust to starve by the wayside,” he once told Der Spiegel. It was only a slight exaggeration. In the nine years he was CEO of the Volkswagen group, he ousted three Audi CEOs. The one who finally lived up to his expectations was the man who would eventually follow him at VW, Martin Winterkorn.

Piëch took the helm of the entire company, Volkswagen Group, in 1993, when it was nearly bankrupt. He exploited that crisis to present himself to skeptical unions and politicians as the only one radical enough to turn the company around. Then he browbeat the Betriebsrat into accepting a four-day week, with a pro rata pay cut. That same year he hired José Ignacio López de Arriortúa, then GM’s head of purchasing, away from the Detroit giant, seeing a kindred spirit in the Basque who had bullied auto suppliers into lowering their prices. The move backfired disastrously. VW ultimately paid $100 million to settle civil claims of corporate espionage and pledged to buy $1 billion in parts from GM.

Piëch boasted of his willingness to threaten employees into giving him what he demanded. Bob Lutz, a veteran of GM, Ford, and Chrysler, recalled in a first-person article for Road & Track last November how Piëch told him the secret of the fourth-generation Golf’s remarkably tight body fits: “I’ll give you the recipe. I called all the body engineers, stamping people, manufacturing, and executives into my conference room. And I said, ‘I am tired of all these lousy body fits. You have six weeks to achieve world-class body fits. I have all your names. If we do not have good body fits in six weeks, I will replace all of you. Thank you for your time today.’ ”

Even then, the reality wasn’t good enough. “The photos were still touched up to make the fits look tighter,” says Bertel Schmitt, who wrote advertising copy for VW at the time.

In 2004, after Piëch had moved from the CEO’s seat to chair the supervisory board, the VW system generated another scandal that dwarfed the López affair. It emerged that the company had, for nearly 10 years (beginning less than two years into Piëch’s reign and soon after the deeply unpopular cuts to hours and wages), been showering high-ranking labor representatives with, among other things, prostitutes for Betriebsrat members and all-expense-paid luxury shopping trips to Paris for their wives. Betriebsrat head Klaus Volkert was treated especially kindly, getting 2 million euros in bonuses over 10 years, while his Brazilian mistress was subsidized to the tune of 400,000 euros. Both Volkert and a VW executive were convicted of criminal abuse of office as a result. Piëch personally signed off on a big, unscheduled increase to Volkert’s pension.

The center-left Social Democratic Party came off particularly badly in the scandal, with senior officials exposed as feasting at the trough. Peter Hartz, VW’s chief of personnel and the architect of Chancellor Schröder’s radical labor reforms, pleaded guilty to criminal charges. It emerged that some sitting SPD lawmakers were drawing salaries of over 5,000 euros a month from Volkswagen, allegedly for nothing in return. (Two lawmakers were convicted of receiving illegal payments.)

The dirt flew in all directions, but none stuck to Piëch. Summoned to testify in 2008, he presented himself as a maligned titan too busy with higher things to worry about such grubby little matters. From the witness stand, he mocked a lawyer who stumbled over his notes as he cross-examined Piëch. “Those who buy Lamborghinis can pronounce it however they want,” said Piëch. “Everyone else should pronounce it properly.”

Volkert, after his conviction, tried to pin the blame on the chairman. “Anyone who knows how things are in the company finds it hard to imagine that all that happened without Piëch,” he told the press. “There was little he didn’t know about.” Piëch has always asserted his innocence and never faced prosecution. He didn’t respond to questions emailed by Fortune.

Volkswagen’s Salvation: Clean Diesel?

It’s against this background, seething with political and family rivalries, that VW made its ill-fated 2005 move to crack open the U.S. market with “Clean Diesel,” the Next Big Thing. At that point Piëch’s turnaround had borne fruit. Early moves into emerging markets such as Brazil and, above all, China, had paid off handsomely. Revenues and profits had taken off.

But the U.S. remained a long-running disaster. VW had nearly 19% market share in Western Europe in 2005. In the U.S. it had a scant 2%. The days when Herbie the Love Bug and camper vans filled with hippies and surfers had captured the public’s imagination were long gone. Between 1988, when VW abandoned a 10-year experiment making a U.S. version of the Golf at an old Chrysler factory in Pennsylvania, and 2011, when it opened a new plant in Chattanooga, the company didn’t make a single car in the U.S. That put it at a big disadvantage not just to Detroit, but to Japanese rivals who had set up stateside.

Clean Diesel would change all that, contended Bernd Pischetsrieder, whom Piëch had plucked from BMW to succeed him as CEO. U.S. gas prices were then soaring toward $3 a gallon, and climate change was looking like an ever more dire threat. Pischetsrieder concluded that if VW could combine performance, modest price, and environmental appeal, it could restore its rightful place in the world’s biggest auto market.

But the U.S. presented daunting regulatory obstacles. American environmental protection has always focused on pollution, particularly Southern California smog—precisely what the NOx emissions from diesels exacerbate. That state’s powerful regulator, the California Air Resources Board (CARB), given extraordinary powers under the federal Clean Air Act, led the U.S. to adopt stringent NOx restrictions.

Europe had taken a different approach. Diesel was noticeably cheaper and more plentiful than gasoline, a crucial advantage in a region lacking in oil. Having signed the 1997 Kyoto Protocol, European governments were also more focused on climate change and the reduction of greenhouse gases, especially CO2. Good fuel economy—the diesel engine’s long suit—reduces CO2 emissions. EU states started to tax vehicles according to their CO2 output. And they placed less importance on NOx and carcinogenic soot, which diesels produce in higher quantities than gas engines.

“A range of policy choices skewed the market in favor of diesel, whereas in the rest of the world this didn’t happen,” says Greg Archer, who heads the Clean Vehicles arm of Transport & Environment, a nongovernmental organization based in Brussels. At the start of the 1990s diesels accounted for about 10% of the light-vehicle fleet in Europe. By 2014, 50% of all new vehicles licensed in the EU were diesels.

A CARB spokesman describes the lab-testing process.Nick Ut—AP

“No One Had the Courage to Admit Failure”

The job of executing on Pischetsrieder’s vision of a hit U.S. diesel car fell to a group of engineers in Wolfsburg. Their key challenge was designing an engine that could satisfy America’s stringent NOx regulations without sacrificing performance or fuel economy, while remaining competitive in sticker price.

This was occurring just after VW received what amounted to a public warning about its emissions. In 2005 the company agreed to pay a $1.1 million fine after the EPA alleged that VW had received numerous reports in 1999 and 2000 about a defective exhaust part, which was causing excess carbon monoxide and other dangerous emissions, but failed to report the defect to regulators, as required, until the EPA came across it in a random test. Only then had VW instituted a recall—of 329,000 cars—at a cost of $26 million. VW did not admit wrongdoing, but it did sign a consent decree promising to “enhance its system for monitoring and reporting emission-related defects.”

Adding to VW’s challenge, the U.S. had announced even stricter rules for 2009. These permitted maximum emissions of 44 milligrams of NOx per kilometer, about one-fourth the 180 mg/km permitted by the Euro 5 standard that would also take effect in 2009. (Even the Euro 6 standard, which took effect in 2014, permits 80 mg of NOx per kilometer—still nearly twice the U.S. limit.)

Diesel trucks have long used a costly and bulky NOx-suppression method known as selective catalytic reduction. SCR involves squirting an ammonia-infused fluid, urea, into the exhaust, which converts the NOx into nitrogen, CO2, and water.

By 2006, as the VW engineers pursued their task, rival DaimlerChrysler was already marketing clean diesel cars that used an SCR system. VW licensed the technology—but then chose not to use it, possibly because of changes at the top.

In November 2006, CEO Pischetsrieder was forced out by chairman Piëch, under pressure from the Betriebsrat. (The CEO had tried to lengthen the work week without full compensation and lost the ensuing battle.) The new chief was Winterkorn, a Piëch favorite, whom he had hired at Audi 25 years earlier.

Even as Piëch maneuvered, there’s a sign that VW engineers were considering the use of software that would let the company cheat on its emissions testing, according to a recent article in the Süddeutsche Zeitung, which attributed the information to a preliminary report from VW’s internal investigation. At that point in November 2006, it appears, it was simply talk; no evidence has emerged that Piëch knew about it.

By August 2007 the deal to use Daimler’s technology had been scrapped. It’s unclear precisely why, though some accounts have posited vanity: Volkswagen wanted its own system.

The pressure seemed to intensify inside VW. It wasn’t “acceptable to admit anything is impossible,” a company whistleblower told Jones Day, according to the Süddeutsche Zeitung. “Instead of telling management that they couldn’t meet the parameters, the decision was taken to manipulate. No one had the courage to admit failure. Moreover, the engine developers felt secure because there was no way of detecting the deceit with the testing technology that existed at the time.” It was, the whistleblower said, “an act of desperation.”

A fateful decision had been made. But that’s not what was presented to the outside world. In spring 2008, VW announced the solution to its U.S. woes: a new engine that used a variation on the direct injection that Audi had used under Piëch years before and many had used since. VW billed it as a “next-generation turbo diesel developed especially for the North American market.”

But the biggest selling point was that this high-performance diesel was clean. This engine had a different technology than VW had previously used to reduce emissions, a solution called the lean NOx trap. The technical details don’t really matter. The bottom line is that the engineers couldn’t get it to work, at least not without unacceptable consequences for fuel economy or drivability.

No matter. The 2009 VW Jetta diesel, equipped with the lean NOx trap and defeat-device software, launched in April 2008 and would soon be followed by similarly equipped VW Golfs and Audi A3s. More than 145,000 of the vehicles would be sold over the next three years.

A Micromanager with Titanic Ambitions

By this time, Piëch had already been out of the day-to-day running of the business for six years. He and the CEO were presented as the Dream Team: Piëch was the visionary patriarch, Winterkorn the perfectionist master of detail. Winterkorn might have been a notch less imperious than the chairman, but he still displayed an almost theatrical officiousness: He publicly dressed down his juniors at an auto salon for failing to build a steering column that could be adjusted as smoothly as a Hyundai’s. He was known for carrying a micrometer to check the minutest measurements of cars. VW routinely transported twice as many vehicles to auto shows as it planned to display because Winterkorn was known for vetoing a particular selection if he detected the slightest imperfection.

Like his mentor, Winterkorn had outsize ambitions. One of his first acts as CEO was to unveil a plan to overtake both General Motors and Toyota by 2018 to become the world’s No. 1 automaker, “not just in units, but in profitability, innovation, customer satisfaction, everything,” as he put it. Winterkorn wanted everything.

His approach seemed to work. VW grew rapidly during his tenure, surpassing Ford as No. 3 in global sales in 2008 and leapfrogging General Motors into second place in 2014. In the first half of last year, VW briefly edged Toyota for the top spot. Between 2007 and 2014, Winterkorn more than doubled the group’s operating profits and dividends. Revenues hit 200 billion euros for the first time in 2014. Still, VW would find it hard to reach the global pinnacle without significant sales of diesels in the U.S.

The Cheating Deepens

As the first decade of the 21st century ended, VW was enjoying accolades and healthy sales for its green diesels. But there were hints that the German auto industry, if not VW in particular, was uncomfortable with the U.S. emissions rules.

Merkel herself weighed in on the issue in April 2010. The Chancellor met that month with California Gov. Arnold Schwarzenegger and CARB chief Mary Nichols at the Four Seasons in Beverly Hills, according to comments that Nichols made to the publication Handelsblatt (which were confirmed to Fortune by a CARB spokesperson).

As soon as Schwarzenegger left the meeting, it seems, Merkel pounced on Nichols and said, “The strict nitrogen oxide limits in California are damaging German carmakers,” Nichols told the publication. “I never experienced a similar intervention against our environmental laws by a politician either before or after.” The lobbying yielded nothing. (A spokesperson for Merkel did not respond to requests for comment.)

Meanwhile there are hints that by 2011, word of VW’s cheating was circulating to higher levels. A whistleblower allegedly revealed the use of a defeat device to Heinz-Jakob Neusser, a Volkswagen brand-development boss and, later, management board member, according to the Süddeutsche Zeitung. (Neusser, who didn’t respond to a request for comment, was suspended after the scandal erupted.)

Roughly three years had passed since VW had begun its deception. The engineers viewed the ruse as a stopgap measure, Volkswagen has suggested, and hoped to abandon it when better technologies became available. Now, in 2011, instead of stopping or slowing down, the company intensified the misbehavior. Volkswagen introduced a new generation of exhaust configuration, which used the more tried-and-true SCR system, in some models.

But even the new configuration employed defeat devices, VW has admitted. The engineers did this, Volkswagen chairman Hans Dieter Pötsch acknowledged in a presentation to shareholders in December, to overcome a major inconvenience associated with SCR. The technology necessitates a tank to carry all the urea that must be squirted into the exhaust. But unless that tank is impractically enormous, the fluid must be replaced frequently by a licensed service station, which would annoy the consumer. VW wanted each tank of urea to last at least 16,000 kilometers, so it could be replaced when the owner came in for a routine servicing and oil change. By installing a defeat device, the urea was conserved sufficiently to meet this goal—although it meant belching illegally high levels of NOx.

Almost 90,000 of these Passat diesels, from the 2012 to 2014 model years, were sold. During that same period VW sold another 180,000 Golfs, Jettas, Audi A3s, and, beginning in 2012, Beetles, all still equipped with the fraudulent LNT system.

By model year 2015 the company was able to introduce a third generation of its Clean Diesel car. All would now come with the superior SCR system—but all still came with defeat software too. Volkswagen sold about 33,000 third-generation vehicles though September 2015.

The “real-world” apparatus that revealed VW’s deception.West Virginia University Center For Alternative Fuels, Engines and Emissions

Doubting Their Gauges

Historically, regulators in Europe and the U.S. have relied on highly controlled lab tests when monitoring pollutants like NOx. The tests are performed on platforms called chassis dynamometers, or dynos, where the car is locked into place while its wheels spin on rollers. The artificial environment lets scientists control variables, like ambient temperature and wind, and ensure that all vehicles are subjected to an identical simulated-driving sequence.

Unfortunately that approach makes it possible to cheat. Software in the car’s engine control unit can detect when the vehicle is being subjected to the unique series of routines that characterize a test. It can, therefore, instruct emissions-control equipment to kick in during a test but switch off under real-world driving conditions.

It is also possible to test emissions during real-world driving, using a portable emissions measurement system, though the process is cumbersome. In 2011, after government researchers conducted a series of those tests, the European Commission found that diesel cars were spewing as much as seven times more NOx on actual roads than they were in the lab. Other experiments—for both gasoline and diesel cars—revealed similar results. (The discrepancies have been increasing. In 2001, European cars of all sorts were getting 7% fewer miles per gallon on the road than they demonstrated on the dynamometer. By 2014 the gap had widened to 40%.)

These results did not necessarily mean that carmakers were using illegal defeat devices. The in-lab test regimen used in Europe was quite old—test cars were never equipped with air conditioning, for instance—and it was possible that the mix of driving situations simulated during the test simply no longer reflected modern-day reality.

Still, engineers at the nonprofit International Council on Clean Transportation suspected that at least some of the disparity might reflect carmakers’ gaming the system and exploiting lax European compliance and enforcement mechanisms. In Europe, for instance—unlike in the U.S.—countries do not spot-check emission levels, and failings, when detected, are not punished as severely. In addition a car model certified as compliant in one EU country must be accepted as compliant in all others—a situation that can lead to shopping for the most lenient testing service.

In collaboration with CARB, the ICCT contracted with a group of engineers at West Virginia University to compare the NOx emissions of three U.S. diesel cars in and out of the lab. The researchers’ hypothesis was that any discrepancy would be far less than what European researchers were finding because of the more robust U.S. regulatory regimen. Armed with such results, the ICCT hoped to persuade the European Commission to beef up its own policing.

Due mainly to happenstance—which models proved easiest to rent or borrow—the researchers ended up with a BMW X5 and two VWs, a Jetta and a Passat, as test vehicles. In the researchers’ test drives, the BMW appeared to confirm ICCT’s hypothesis: Its emissions were as good on the road as on the dyno, staying within the NOx limits.

When they tested the VWs, however, the results were perplexing. “We were seeing a disparity,” says Greg Thompson, the principal investigator. At first they doubted their gauges, he says, but when the data persisted, “we knew there was something causing a dual operation.” The Jetta was belching 15 to 35 times the permissible levels of NOx, while the Passat was emitting five to 20 times the maximum.

That didn’t prove VW was using a defeat device. “We then had just two data points,” Thompson stresses—two vehicles from a fleet of thousands. “There could’ve been reasonable explanations.” Maybe something was just malfunctioning.

The key findings of the West Virginia group—already known to CARB and the EPA—were revealed for the first time on March 31, 2014, at a conference in San Diego on emissions testing. Though the researchers identified the test cars only as Vehicles A, B, and C, the makes would have been easy to guess for auto engineers. In the U.S., VW was the only manufacturer selling a passenger diesel with a lean NOx trap, or 2.0 liter diesels with an SCR system.

The Unraveling

On April 7, ICCT engineer Francisco Posada says, he got an email from a VW of America official seeking to verify which cars were VWs. The news appears to have reached Wolfsburg quickly. By late April an internal Volkswagen presentation discussed strategies the company could use in response, according to a recent New York Times report: “One option was for Volkswagen to offer to update the engine software. But the update would not bring emissions down to the required levels, the presentation said.”

The West Virginia University researchers’ 117-page report was published on May 15, 2014. “We were just thinking, How do we fix this?” says CARB spokesperson Stanley Young. “We were still assuming it was a technical issue.”

Some people at VW, it appears, suspected it wasn’t a technical snafu—and that information may have reached the top of the company. According to accounts in Bild am Sonntag and other publications, in May 2014, Bernd Gottweis, a former VW official who had come out of retirement to help with the emissions issue, wrote CEO Winterkorn a memo about possible repercussions from the report. The company “would not be able to give officials ‘a sound explanation for the dramatically elevated’ nitrogen oxide emissions,” his memo warned, according to the New York Times, and regulators were “likely to investigate whether Volkswagen cars were equipped with ‘a so-called defeat device.’ ” (VW acknowledged in a recent press release that Winterkorn received a memo about the report in May 2014 “in his extensive weekend mail.” The release added, “whether and to what extent Mr. Winterkorn took notice of this memo is not documented.”)

CARB took the lead in questioning Volkswagen about the results and doing additional testing. Some 10 meetings were held between CARB’s engineers and VW’s, says CARB spokesperson Young. (His organization did not permit its engineers to speak to Fortune because of ongoing litigation and investigations.)

“We got a lot of pushback,” according to Young. “They said our testing was inaccurate and didn’t take into consideration a variety of circumstances that occur on the open road, in traffic, load, incline, exceedances with engineering limits.” The Justice Department and EPA have since alleged in their suit that VW officials “impeded and obstructed” CARB’s inquiry by providing “misleading information,” “conceal[ing] facts,” and making “affirmative misrepresentations.”

By November 2014, a second memo about the U.S. diesel issue had been sent to CEO Winterkorn, according to the company. At that point, VW was estimating it would cost 20 million euros to fix the problem.

The next month Volkswagen suggested to CARB that since it was already planning a voluntary recall relating to some hardware durability issues in the exhaust system, it would make software changes at the same time that would fix the emissions anomalies. The recall was completed by the spring of 2015.

Photo: Frank May—Picture-Alliance/DPA/AP

Click image to enlarge.

As that was occurring, turmoil bubbled up yet again inside VW. The patriarch, Piëch, made one move too many. When the company’s momentum began to cool, he attempted to oust Winterkorn. This time, though, the protégé outmaneuvered his mentor. Winterkorn allied himself with the unions—and Piëch’s own cousins. The board turned against him, and the chairman stepped down in April.

A year had passed since the study revealing VW’s odd emissions results and since Winterkorn received a memo warning of a possible defeat device. The company kept selling diesels—and CARB’s engineers kept testing. The results got fishier. “One of the telltale signs,” says CARB’s Young, “was that the car was running much cleaner when cold than when it was hot—contrary to standard automobile engineering.”

Finally came the coup de grace. “We tweaked the test in the lab to fool the car into thinking it was no longer in the lab,” says Young, “and that it was out in the open road. The emissions jumped.” Clearly the car had a defeat device.

NOx-ious Diesels: These models, all with TDI technology, were among the 15 with cheating software. Their value is diminished, and VW must now fix—or buy—the 580,000 sold in the U.S. (Another 10.5 million, including other models, were sold elsewhere.)Photos: Courtesy of VW, Audi and Porsche

Confession and Denial

In July 2015 the EPA ran out of patience. It issued an ultimatum: The agency would not certify any of the VW’s 2016 model year 2.0-liter diesels until it received a credible explanation for what CARB was finding.

In meetings over the next several weeks, according to CARB, VW engineers finally admitted what they had denied for months—that since 2008 the company had installed undisclosed software in diesel engines that triggered a “second calibration intended to run only during certification testing.” On Sept. 3 a Volkswagen official formally signed a document to that effect. The document remains confidential, but CARB has stated that in it “VW admitted … that it designed and manufactured its 2.0-liter diesel vehicles with defeat devices to bypass, defeat, or render inoperative elements of the vehicles’ emission-control system.” (VW declined comment.)

The world learned of the scandal about two weeks later, when the EPA issued a formal notice of violation relating to nearly 500,000 2.0-liter diesel cars—stretching across seven model years and three generations of exhaust-treatment configuration.

The method shows how finely tuned the cheating was. A key phase of the standard U.S. emissions test lasts exactly 1,370 seconds. Audi’s software, the regulators discovered, was calibrated to emit a legal amount of emissions for precisely 1,370 seconds. When the 1,371st second elapsed the software switched settings, so that the car spewed up to nine times the permitted amount of NOx, the EPA alleges. How’s that for German engineering?

On Nov. 2 the EPA issued another notice of violation—this one for five models of Audi, the Porsche Cayenne, and the VW Touareg. Their engines were developed by Audi engineers in Ingolstadt, Germany, about 300 miles south of Volkswagen’s Wolfsburg facility, where the first group of purported bad-apple engineers worked. That means two groups of engineers were allegedly breaking the law in parallel for seven years, with seemingly little in common except the upper-level executives they answered to.

Greenpeace activists demonstrate at a company plant in Wolfsburg.Peter Steffen—AFP/Getty Images

Aftermath: Bad to Worse

VW’s response to the exposure of its chicanery was revelatory in its confusion. Within a five-day period, CEO Winterkorn publicly apologized on behalf of the company, disavowed any personal knowledge of wrongdoing, vowed to stay on as CEO—and then resigned. The board, for its part, pledged a full and independent investigation but then confidently averred that Winterkorn “had no knowledge of the manipulation of emissions readings.” The board also promised to establish “a new mind-set” at the company, with “more capacity for criticism”—seemingly conceding there was something poisonous about the culture Winterkorn presided over.

So who did the board select to lead the “unsparing” cleanup it was promising? Two company insiders with long-term ties to Winterkorn. Matthias Müller, Porsche’s chief and a 30-year VW veteran, was named CEO, while CFO Hans Dieter Pötsch was moved to chairman. Since September at least 11 top executives, including two top engineers who oversaw development of the engines in question, have been suspended or have departed.

More than once the company has shown signs of being in denial. In early November, when the EPA declared that VW’s 3.0-liter engines were also using defeat devices, the company insisted that “no software has been installed” in those vehicles “to alter emissions characteristics in a forbidden manner.” But 21 days later its Audi division, which made those engines, admitted that, yes, they too incorporated a defeat device.

The scandal’s impact is not abating. Last month VW put off the announcement of its annual results until April and postponed its annual shareholders meeting until June. The company plans to reveal preliminary results of the Jones Day internal probe in late April.

The German KBA, or Federal Vehicle Agency—an arm of the Ministry of Transport—has already approved the company’s proposed European recall in which VW will “fix” most of the millions of affected cars there with a software update, requiring just 30 minutes to effectuate. The agency has evidently accepted VW’s contention that the switch will have no appreciable impact on fuel economy or performance—begging the question why the offending software was ever put there in the first place. (European cars had different emissions-reduction hardware than U.S. cars, so the software had different impacts, VW has said. It declined to elaborate, however, for Fortune.)

In the U.S., Judge Breyer is pushing the class action forward on a very fast track and appointed former FBI director Robert Mueller to ride herd on the parties to settle. “I am deeply concerned about vehicles being on the road which are polluting,” Breyer said at a hearing, during which he recalled his youth in a California that was choked by smog. “We all ought to move as quickly as possible to resolve this in a sensible way.” In February the judge, fed up with waiting, slapped VW with the March 24 deadline to propose specific “fixes”—or be prepared to start buying vehicles back.

Both sides have committed to complete the discovery process by the end of 2016—lightning-quick by U.S. standards. But it seems increasingly unlikely that any fix for the lean NOx trap vehicles—roughly 60% of the diesels involved—will ever be approved by regulators. A buyback may be needed for those.

Plaintiffs lawyers—and regulators too—will also be pressuring VW for steps known as “mitigation” to make up for the damage to the environment that can’t be undone. These might include commitments by Volkswagen to expand its efforts in the arena of electric cars. Indeed, CEO Müller has already promised a range of at least 20 hybrid or electric vehicles by 2020.

In Europe, meanwhile, German carmakers continue to fight emissions regulations. The European Union has moved forward with plans, already on track before the scandal, to mandate on-the-road testing in 2017, supplementing the all-too-easy-to-fool lab testing. But Merkel reportedly pressed the EU to relax the new standards, apparently after she was lobbied by the German Auto Industry Association. Sure enough, the new European rules will permit diesel cars to produce more than double the NOx on the road than they’re permitted on the dyno until 2020, and even after that, 1.6 times more.

Back stateside, it’s a much different picture. Judge Breyer doesn’t give a damn what Merkel or the European auto industry think. Here, VW is defenseless and grievously exposed. It’s stuck on cruise control, hurtling toward a devastating reckoning.

A version of this article appears in the March 15, 2016 issue of Fortune.